With the introduction of certain regulations, some prime brokers are shedding clients while administrators have begun to exit hedge fund administration altogether. Why is this happening?
I believe that the two key factors are cost and profitability.
Historically, many prime brokerage firms have seen the fund administration space as a necessary evil and, given the increasing costs and complexities, many are happy to move away from it. They’re reverting to their core businesses in the custodial, depository spaces and directly related activities.
Some of the larger institutional players are losing money on a daily basis from their fund administration business, and that is significantly eating in to profits in other areas.
Some have built up their market share by offering attractive rates to clients, but they haven’t necessarily accounted for the ever-increasing regulation, and the amount of extra work to be done. They are stuck in arrangements that are now quite hard to get out of. In many cases they can’t terminate the relationship with a client, because it will damage their relationship with that same client in the prime brokage and custodian business.
Instead, they are considering offloading the whole fund administration business, which sounds like a simple solution. But then the question is whether anyone is going to be interested in buying that business, which may not be attractive in terms of costs versus revenues.
Can they solve the problem of compliance by doing this, or are they just postponing it?
The problem is not the introduction of new regulations, it’s that they are losing money, and they are losing money because they took on business too cheaply in order to gain market share.
This shift towards outsourcing administration won’t affect the impact of the regulations, or delay them. Whoever ends up providing the administration service will have to assist fund managers in complying with whichever regulations affect them.
These regulations are here to stay. The fact is that the shape of the market, and the players in it, might be different to what people might have thought, but that’s all that will change.
In many ways these are positive factors. The requirements of the depository under the Alternative Investment Fund Managers Directive (AIFMD), for example, are heavily weighted towards the big institutional players and it was predicted that they would only agree to provide the depository services if they got the administration business as well.
That was one of the biggest anticipated challenges to the independent administrators, but actually depositories have not been so keen to stay in that space, which takes some of the pressure off of the independent firms.
If you leave the prime brokers and the specialist fund administrators just doing what they’re best at, that’s preferable to having a small number of brokers or depositories covering all corners of the market. That makes for a positive marketplace, which is good for the industry, and therefore good for the consumer.
Have the changes led to positive effects for the end users?
People have been worrying about the outcomes of the regulatory changes, and rightly so.
There were depositories that gave their clients two options; go with them for both depository work and administration, or leave their administration where it was, and pay extra for the additional risk. That appears to have backfired, and I don’t think they were ready for it.
It does open up the space for more of a status quo, as there is a space for specialist fund administrators within the AIFMD regulations. If a client remains with the specialist providers, that will have less of an overall effect on the costs of running a fund, which is good for the consumer, and good for the industry.
The regulation has definitely been positive in terms of transparency, but whether it is positive to the end user, I think the jury would still be out on that.
Some estimates suggest that AIFMD alone could cost managers more that £1 million a year, and a big chunk of that could be passed down to the shareholders. The shareholders do benefit from having increased transparency, but they could also suffer because the fund isn’t likely to perform as well.
The increased transparency does give shareholders the chance to compare managers and funds more freely and to choose those that are regulated, and they may take some comfort in that. The bottom line is transparency versus fund performance, and I think it is going to take some time before anyone can say whether the regulators have got the balance right; whether it has been good for the market or whether it is costing the shareholders too much.
Is all of this change distracting fund managers from their primary lines of business?
There is no one-size-fits-all answer to this, but many of the small to medium-sized managers have had to make very significant changes in a relatively short space of time, and that has had an effect in terms of resources and cost.
It’s hard to say whether the greater challenge is the time that it takes up or the actual financial cost, but either way, it is distracting managers.
With huge regulatory and reporting changes, managers have woken up to the fact that they cannot get away from tax transparency legislation, and I think the fund industry in general has woken up to the Foreign Account Tax Compliance Act (FATCA). This had to be dealt with and it proved to be a challenge that most managers and fund boards worked on, accepted, and did what they had to do.
On the back of that, other transparency regulations came out of the EU and US, which just proved to be an extra headache. There were multiple regulations hitting managers from all sides at the same time, and I think it was the managers trading EU derivatives that have been hit the hardest.
They have had to deal with the European Market Infrastructure Regulation (EMIR), AIFMD and its transparency obligations, and tax transparency, all at the same time, and that has been a challenge that some have tackled better than others.
It was never an easy space, particularly for small start-up managers, but it has become significantly more difficult with the extent of the regulations that have been introduced, and the additional costs of complying with them.
Do you think that’s going to let up anytime soon?
The pace of new regulations will slow down—at least the pace of major regulations. This year is the due date for a review of AIFMD to see if the regulators are going to widen the net, and in 2018 there will be more reviews.
Rather than bringing in new regulations, in the next two to three years the challenges are more likely to be an extension of FATCA, or an equivalent, across other jurisdictions worldwide.
Most managers and service providers, in particular those with forward planning, have put a structure in place to cope with FATCA on a global basis, effectively to prepare for what we know is coming down the line.
In the future, the hard work will already have been done and we will just be using the same platforms to widen the reach of what is already in place.
In terms of AIFMD, the regulators have some catching up to do. Now, with the Annex IV reporting beginning in earnest, they need some time to review what they have got before we can tell if the directive is going to be a success or not.
There won’t be so many new regulations coming out, more of a consolidation of the existing frameworks that have been put in to place over the last couple of years.
Do you find this reassuring?
I think the industry just needs to sit back, take a breath and take stock of all the changes and challenges that have come up over the last three or four years. At some stage, the regulators have to slow down and assess the industry. Regulations are there for a reason, and that reason is to protect shareholders.
We need transparency, but not so much that we’re looking beyond what adds value to the marketplace. The regulators have to ask themselves if they are doing things for the right reasons, or if there are other ways to improve market stability and investor protection. Hopefully, they will come to a sensible balance in the next year or two.
There will always be things that can be tweaked and improved, but now the structures of the regulations are in place, it’s just a matter of consolidating and improving the role of existing regulations, rather than introducing significant new ones.
We should only move on from here if it is beneficial for the industry overall, not just for the sake of moving. Yes, we can improve the frameworks, but we should not be looking to introduce anything new unless there is a very strong and rational case for it, and a clear benefit behind it, too.
← Previous interview
BNP Paribas
Frédéric Beck
Image: Shutterstock 
